Why, in your view, is now a good time to invest in fixed income, and, in particular, EM corporate bonds?
We believe the back up in yields we have seen globally this year makes fixed income more attractive to investors than at any stage - since the Global Financial Crisis (GFC). In our view, EM corporate bonds can offer some significant advantages over broader fixed income. An uncertain growth, inflation and rate environment is something many EM corporates have lived with for years, whereas it has come as a shock to the developed world after years of low rates and low inflation. Coupled with some of the highest duration adjusted spreads available anywhere within the fixed income universe, we believe EM corporate bonds should be attractive to many long-term investors.
Why are EM markets important to impact bond issuers and what is driving growth in the EM impact bond market?
This market has grown rapidly in the year to date. We expect it to keep growing and believe it could double in size over the next two or three years. The EM impact bond market is now over US$300bn2 in size and there are two main reasons why it is growing so quickly. Firstly investors are looking for ways to deploy capital, not just to achieve financial returns but also to deliver various specific beneficial impacts. Secondly, emerging markets have many different economic and social needs and therefore present myriad opportunities to make various positive impacts through investment. Issuers are also becoming increasingly adept at developing projects compatible with the needs of impact bond investors and we see very healthy supply and demand levels across this investment sector.
What potential benefits can EM corporate and impact bonds offer global investors?
We believe EM corporates have consistently been one of the best performing asset classes over time versus the rest of the EM debt universe and the developed market investment grade market. In our experience, investors in the EM corporate space also tend to get paid for excess default expectations without actually suffering excess defaults compared to other fixed income markets. From an impact bond perspective, the scale of need across EMs is greater than in many more developed markets and the innovation taking place within the EM impact bond sector is, we believe, presenting some compelling new opportunities to investors.
How can investors best gauge the attractiveness/inherent risks in emerging markets?
We believe there are specific advantages of investing in EM corporates. In times of stress, sovereign debt defaults tend to be significantly higher in EMs than DMs. But for EM corporates, long-term index defaults have been in line with developed markets since the GFC. This differential offers some healthy dispersion between the EM sovereign and corporate debt space. While all investments carry some degree of risk, our view is that the investment risk presented by the EM corporate debt space should not be overstated. In short, EM corporate indices have consistently offered excess spread compared to developed markets without suffering excess defaults.
No doubt the risks of a “higher for longer” interest rate environment will impact EM economies and EM corporates, as it will impact issuers globally. But at a macroeconomic level, over the past two years many EM economies have tended to be models of fiscal orthodoxy and we haven’t seen any recent examples of major EM economies doing anything that was particularly unexpected or untoward. And at an issuer level, companies are at their strongest fundamentally for a decade, leaving EM corporate bonds relatively well positioned for a more uncertain world.
What do you see as the likely default rate in the EM corporate bond sector in the months ahead?
As in other credit markets we would expect default rates to increase in the year ahead, but without seeing a major spike in defaults outside of well-known trouble zones such as China property, Russia and Ukraine. The good news for EM corporates is that coming into this higher rate, slower growth environment, their leverage is at its lowest, and the interest cover at its strongest, for a decade. That said, we would expect some level of defaults among weaker companies which have consistently faced operating or financial problems. It is worth noting that investors in both EMs and DMs now tend to be much less forgiving of companies in difficulty than they were in the past, making stock selection increasingly important.
How big a factor are current inflation levels in EMs versus more developed markets?
In the developed world we have been used to low inflation levels for over 20 years. That has not been the case across much of the emerging world. EM countries have variously experienced bouts of inflation so, to some extent, are more used to these pressures than DMs. Across EMs economic growth is currently relatively strong and inflation looks to be under relative control with some EM central banks expected to cut interest rates in coming months, having hiked well ahead of the US Federal Reserve (Fed). Broadly, we believe the inflation question is more of a problem for developed markets at this time, though if the Fed rates do remain higher for longer, it will inevitably lead to knock-on effects for EM.
How optimistic are you about the market outlook for 2024 across the EM debt universe and are there any specific geographies/sectors you are particularly focused on?
At a macroeconomic level, much will depend on what happens in developed markets in the year ahead and thus we are adopting a cautious outlook in the short term. While most EMs are seeing relatively strong economic growth, the external influence of economic conditions in DMs, currently grappling with uncertain growth, inflation, and rate environments, could inject some potential uncertainty.
From a sectoral perspective we are very interested in two specific areas within EM markets in our impact strategies: telecoms infrastructure development and renewables. We see structural opportunities in these areas over the next three to five years as their infrastructure is built out across EMs and both sub-sectors tend to attract businesses with the potential for structural growth. With telecoms in particular there is huge growth potential in markets such as East, West and Southern Africa. These are regions where many millions of people currently live without access to 4G telecoms coverage.
Elsewhere we are very excited by the innovation we are seeing in impact bond markets across EM. The world’s first tradeable blue bond, biodiversity bond and gender equality bond all came from EM and we expect to see more innovation over the next 12-18 months.